US Economy: On a Knife’s Edge

Gross Output Remains Under Pressure

We should mention right from the outset that recent data releases – weak as most of them were – are still not confirming an imminent recession with certainty. The situation remains a bit fuzzy: we see a lot of weakness in important data, and considering the overall picture – which includes what is happening globally – we can infer that the likelihood of a significant economic downturn this year is extremely high, but it’s not inevitable. While it is still possible that a recession can be dodged this year, that seems a low probability outcome by now.

Last week the government has updated the gross output (GO) per industry data, which means we now have the picture until the end of Q3 2015. In terms of GDP, Q3 wasn’t much to write home about either (2% real), and we can see from GO that there has been weakness in quite a few business areas. The parts of the economy that are responsible for the bulk of wealth creation didn’t really do all too well. Our suspicion that the trends observed in the Q2 gross output data would continue has been confirmed – and in all likelihood, Q4 will once again show weakness. Below we compare the y/y change rates of selected gross output data to those of new orders for capital goods and industrial production.

The lines ending in Q3 show the gross output data of: all private industries, mining, manufacturing, wholesale trade, retail trade. As you can see, only retail sales managed to show positive growth momentum among these – growth in every other sector (including the combined data) has weakened further, with manufacturing, mining and wholesale trade all in negative territory (note that utilities and construction output, which are not shown above, both grew). The black line depicts the growth rate of new orders for non-defense capital goods, the purple line (which is the most up-to-date series at the moment) shows the y/y rate of change in industrial production – which has likewise turned negative – click to enlarge.

The data shown above are definitely consistent with what is normally seen at the onset of recessions. However, there are historical examples of “false positives”, one of which we will discuss further below, as it seems relevant to the current situation. First a few more words on gross output though. As he always does when the data are updated, Mark Skousen has discussed them as well and has published an update of the adjusted GO/GDP growth comparison chart:

“Gross output (GO), the new measure of U. S. economic activity published by the Bureau of Economic Analysis, slowed significantly in the 3rd quarter of 2015. And the Skousen B2B Index actually fell slightly in real terms in the 3rdquarter. Both data suggest the possibility of a mild recession developing in 2016.

Based on data released today by the BEA and adjusted to include all sales throughout the production process, real GO grew by only 2.5% in the 3rd quarter of 2015, almost half the rate in the 2nd quarter (4.6%). Adjusted GO reached $39.2 trillion in the 3rd quarter, more than double the size of GDP ($18.0 trillion).

In nominal terms, the adjusted GO growth rate declined from 6.3% in Q2 to 2.3% in Q3. In the same period GDP fell from 6.0% to 2.7%, illustrating the higher degree of volatility of GO compared to GDP (see chart below). The higher volatility indicates that GO might be a better indicator of economic activity than GDP, since GO includes economic activity that GDP leaves out.”

(emphasis added)

Dr. Skousen is only looking for a mild recession at present. As he remarks further:

“The GO data and my own B 2B Index demonstrate that total US economic activity has slowed dramatically. A recession could develop in 2016, although I expect it to be mild.

B2B spending is in fact a pretty good indicator of where the economy is headed, since it measures spending in the entire supply chain, and it indicates tepid growth and maybe even a downturn.”

We should perhaps add that as far as we are aware, Dr. Skousen is by nature an optimist…:). Considering that the GO data only show the situation up to the end of Q3 and we have in the meantime seen further weakness in assorted surveys, gross output has likely continued to worsen. Much will also depend on developments in the rest of the world and future trends in money supply and credit growth. If e.g. China’s credit bubble were to suffer a serious contraction, it would likely have wide-ranging effects.

Recent Survey Data

The Philly Fed and Dallas Fed manufacturing surveys were recently released. The former came in “less bad than expected”, but remained in negative territory. Apparently one of the reasons for the somewhat slower pace of contraction was a notable downward revision of the data of previous months, so one can hardly call the release “good news”.

The Dallas survey was an unmitigated disaster that made landfall way outside the range of what were already very modest expectations. The consensus was for the headline index to clock in at minus 14, which sounds grim enough (with expectations ranging from -10 to -17). The actual number was a rather more alarming minus 34.6. The production index was a negative standout, plunging a full 22.9 points from 12.7 to minus 10.2. Here is a chart of these particular catastrophes:

Obviously, the Dallas survey is strongly influenced by troubles in the oil patch. More on this follows further below, but first we want to show two comparison charts our friend Michael Pollaro has mailed to us, which compare the new order data of the two surveys with the average of the new orders indexes of all regional surveys and the national ISM new order component:

National ISM figures always lag in downturns and overall tend to act a bit better than many of the more volatile regional data, but it is to be expected that the gap to the regional average will soon narrow.

The Significance of the Oil Price Crash

The last time a sharp downturn in Texas was clearly triggered by an oil price crash was in 1986. The size and speed of the plunge in crude oil prices at the time was comparable to the recent decline and economic conditions in the region deteriorated significantly. Below is a chart of the Texas leading index published by the Fed. Whenever it has declined to near its current level in the past, a nation-wide recession either soon followed or was already underway – except in 1986:

Texas leading index: a decline to current levels was usually associated with impending nation-wide recessions, but the 1986 oil price crash caused a downturn that remained confined to the region – click to enlarge.

It appears that many observers believe that the current downturn is ultimately going to result in a similar outcome. There are certainly many parallels to the 1986 event, but we believe it does not necessarily follow that it will remain similarly well contained this time around. We would actually argue that the current downturnhas to be more serious and will have more far-reaching effects than the one in 1986.

The recent shale boom was of different magnitude and importance, and has made a major contribution to capex and employment growth in the post GFC recovery. US oil production has more than doubled, returning to levels last seen 40+ years ago. The debt growth associated with the boom has been quite stunning as well. The economy overall has been a lot weaker than in the mid to late 1980s, so it stands to reason that the current boom’s demise will be of greater moment than the oil bust of 1986.

In addition, the still growing problems in the junk bond market are providing indirect evidence that the negative effects of the energy bust are rather unlikely to remain confined to the main oil-producing regions.

Merrill US high yield Master II Index and CCC and below effective yields – the surge in yields continues – click to enlarge.

As an aside: the S&L crisis, the 1987 stock market crash and the recession of 1990 all followed shortly after the 1986 oil crash, which was probably no coincidence.

Conclusion

We may not yet have final confirmation that a recession is imminent, but so far nothing suggests that the danger has receded.